If you’re a casual observer of tech, you’ll no doubt have noticed that Google announced a rather large acquisition the other day. Heck, it even got prime time and first page news coverage here in Germany, albeit admittedly with the unavoidable spin towards matters of incursions of privacy. It seems this acquisition got people talking.

Market Validation

I had a post sitting in my drafts folder which was picking up on this piece at Slate reporting on the financing round Nest was raising about two weeks ago.

But there’s a real reason why investors like weightless social media companies more than manufacturers of tangible products. It’s called “scale.” The next 100 million Facebook users will add very little to Facebook’s overall cost. But they’ll substantially increase the size of Facebook as an advertising platform. And these companies also benefit from network effects. […]

A company like this can, at the peak of its powers, achieve totally obscene profit margins. So you want to pay a lot for a firm that has even a small shot at that kind of ring.

The issues of scaling are of course there. Marginal costs in hardware businesses are not to be underestimated. However, potential profitability is one concern for potential venture investors. The overriding concern is about liquidity events – how big can potential exits go, and how likely is an exit vs. a wind-down of the company. And that’s where marginal costs play a big role, because with pricey user acquisition and lesser network effects, the hockeystick that so many of the investment community have come to rely seemed to be an unfeasible proposition for hardware. It’s the breakout successes that make or break a fund. You need an investment with crazy multiples to survive in an industry that has power laws in its very foundations.

The Nest acquisition proves that those exits are possible with hardware, too.

Multiple sources say Kleiner Perkins was Nest’s biggest investor, and was able to invest $20 million in Nest across the A and B rounds. Our sources say the $3.2 billion cash price Google paid for Nest will generate a 20X return for KPCB — which matches the 20X multiple Fortune’s Dan Primack heard from a source. The money came from 2010′s $650 million KPCB XIV fund, which means Kleiner returned over 60% of the fund with just its Nest investment.

I expect this to increase the hunger for hardware startups among many of the institutional VCs whom so far have sat on the sidelines. The market is validated, and this should encourage additional investments.1

Scaling is still hard

One of the main advantages that the Nest team had from the get-go over potential competitors in the space was its intimate knowledge of manufacturing and supply chains. Coming from Apple, they had to figure out how to manage production of millions of units of any given product. This is knowledge that necessarily is hard earned. But it gets worse: The whole discussion around MVP and lean is in direct opposition of what’s necessary in a hardware startup. You don’t have the luxury of adjusting your product mid-flight, and A/B-testing your way to success would be prohibitively expensive.

MVP and product-market-fit are reasonable ways to go about a software startup, where your feedback loops are much tighter, and you can learn from your customers much more readily. Further, most startups start gathering feedback from users with what are essentially prototypes.

Prototyping in hardware has come down in cost massively, and we see a lot of experimentation as a direct result of that. However, we also see a lot of those experiments hit the brick wall when they have to deliver to 1,000 or 10,000 customers. Often, their prototypes haven’t made it to the DFM-stage, and the resulting re-design and re-engineering add non-trivial amounts of time to the roadmap. I fully expect to see more movement here, as companies and accelerators strive to fill this void and help startups navigate complex supply-chain issues.

Don’t bank on connectivity

This is a point I’ve been talking about repeatedly. Nest’s proposition wasn’t an “internet-connected” thermostat. It was the “learning thermostat.” As such, it took an everyday experience and made it better by adding connectivity. This is the core differentiator to a lot of other “connected objects” whose prime differentiator is connectedness without any fundamental changes to the product experience, oftentimes even degrading the usability of said products. This latest addition to LG’s product portfolio is a good example of that, and would be a good addition to this ongoing collection.

An especially interesting characteristic about the Nest, but the Withings product range as well, is that they do not rely on any Gateway boxes, and thus avoid even the appearance of geeky and tech-heavy tools. Rather, they are products that work on their own, without customers having to purchase any enabling equipment. This is, I believe, a huge part of their success formula.2

This is part of a larger trend where I see “Internet of Things” increasingly becoming a term for those of us who work in the industry, while completely being irrelevant in product descriptions and marketing. We might be interested in how products work together, how the connective tissue is going to be used and what those new products might look like. Customers, on the other hand, are mostly just interested in better product experiences. They couldn’t care less.

Disclosure: Both Nest and Withings have been clients of mine in the past. This post reflects my personal opinions on the market and is not informed by their positions.